The Asymmetry of Our Pricey Stock Market

Yesterday, the S&P 500 suffered its first decline in excess of 1% since October 11th. Volatility has essentially been non-existent since the election, with the VIX hovering around 12, well below its long term average of approximately 20. Investor complacency has been building, evinced in part by the record level of flows to ETFs in January and February, as those late to the party increasingly have been throwing money at the market so as not to be left further behind.

So is recent performance indicating a crack in the market’s armor?

There are growing concerns about the Trump administration’s ability to make meaningful headway on tax reform, regulatory reform and infrastructure spending in 2017. And it’s been optimism around those same themes that has served as a partial catalyst to the market’s post-election performance, along with steadily improving economic data let’s not forget (sorry DJT, you can’t take all the credit). Piling these concerns on top of what many investors admit is a pricey market, and you’ve got a recipe for trouble.

Consider the following observation from a recent research report from The Leuthold Group:

“Even if we estimate potential upside in the S&P 500 median stock under the theory that each of four valuation ratios — Trailing P/E, Normalized P/E, Price/Cash Flow, and Price-to- Book — reaches its individual all-time high set during the 1990s’ market mania, the median stock would gain a mere +12% from here!”

That’s quite a revelation. There certainly isn’t much upside, at least if investors are counting on further valuation expansion, which has been a powerful force during this eight year bull market.

Institutional investors began prepping for more difficult times last year, according to a recent story in FundFire. In a study commissioned by Natixis, 137 corporate pension plans, 121 endowments and foundations, 111 pension or government pension plans, 95 insurance companies and 36 sovereign wealth funds were surveyed, and the results included the following:a

70% of investors are willing to underperform to protect capital. In addition, half of them plan to decrease return assumptions in the next 12 months.

76% of those surveyed indicated that they would be increasing their use of alternative investments.

73% of investors consider the market environment more favorable to active managers (this at a time when retail investors are increasingly favoring passive options).

While diversification of any kind away from U.S. equities has been quite frustrating for a prolonged period, investors simply can’t afford to forget that nothing lasts forever. Long/short equity funds, among other alternatives, could be increasingly important for those wishing to narrow the range of potential outcomes in a less equity-friendly environment. As we anxiously await for the Sweet Sixteen to begin, we are reminded that March Madness routinely produces big upsets and that defense wins championships, so the question is, is your portfolio ready to handle an upset market?